Chapter 35 - Share Based Payments PDF

## Chapter 35: Share-Based Payments ### Lesson 1: Share-Based Payments and Their Implications for the Company **Technical competency:** 5.2.3 Evaluates sources of financing **Learning outcomes:** * Explain the implications of stock options. * Explain the implications of restricted share units a...

## Chapter 35: Share-Based Payments ### Lesson 1: Share-Based Payments and Their Implications for the Company **Technical competency:** 5.2.3 Evaluates sources of financing **Learning outcomes:** * Explain the implications of stock options. * Explain the implications of restricted share units and performance share units. * Explain the implications of share appreciation rights (SARs). * Discuss other issues related to share-based compensation plans. Share-based payments have traditionally been used by companies as a way to reward and to attract top management and key employees. They are used to motivate employees with a flexible way to attain share ownership in the company, align employee and shareholder interests, and reward employees, based on stock price performance. Share-based payments can also be used as a form of consideration to pay suppliers for goods and services. Share-based compensation provides executives and employees with the opportunity to share in the growth of their company and, if structured properly, can align employees' interests with the interests of the company's shareholders. These arrangements are intended to encourage management to act in a manner that will increase the company's share price. This chapter discusses three types of share-based compensation plans that involve stock options, share units, and share rights. It examines how these plans work and their implications for employees and for the company, as well as the advantages and disadvantages of each form of compensation. ### 35.1 Types of share-based payments A share-based payment is consideration paid in the form of the entity's shares or a reference to the entity's share price, in return for services provided by suppliers or employees. These share-based payments can be settled in equity (issue of entity's shares), cash, or both. Share-based compensation is a component of an employee's total compensation package. It often represents a significant portion of the employee's total compensation, depending on what the compensation is actually worth to the employee after the vesting conditions have all been met. Below are three common types of share-based payments to employees: employee stock options (ESOs), restricted share units (RSUs) and performance share units (PSUs), and share appreciation rights (SARs). ### 35.2 Share-Based Payments to Employees - Stock Options An ESO gives an employee the right to buy a share in the company at a specified exercise price within a specified period. Relevant terms related to a stock option include the following: * **Grant date:** the date on which the employee receives the option as a form of compensation from the company. * **Grant date price:** the current market price of the share on the grant date. * **Expiry date:** the date on which the option expires and can no longer be exercised (this period could, for instance, be as long as 10 years) * **Exercise price or strike price:** the price the employee will pay for a share when the option is exercised. * **Exercise date:** the date on which the employee exercises the option. * **Vesting date:** the date on which the option can first be exercised. ESOs are usually subject to the satisfaction of vesting conditions. These conditions can include continued employment and achievement of performance goals, and these conditions must be met before the stock options can be exercisable. For example, if stock options vest after four years, this indicates that the vesting period is four years and the employee cannot exercise the options until after this period. Additionally, if the employee leaves during the vesting period, the options are forfeited. Rather than being based on time, some stock options can vest only after certain performance goals, such as achieving a revenue or earnings target, have been met. Employees will only exercise their options when the current market price of the share is greater than the exercise price. When this happens, the employee realizes value equal to this difference. Therefore, employees who have been granted stock options hope that the share price will go up and that they will be able to gain by exercising the option. These employees will purchase the share at the lower exercise price and then sell the share at the higher current market price. The downside risk for employees with stock options is that the share price never exceeds the exercise price during the exercise period. In this case, the option expires as worthless and the employee has ultimately received nothing. This structure can also be used with suppliers but, instead of benefitting the employee, it would benefit the supplier. Note that for grants of options to suppliers, the options will generally vest immediately. ### 35.2.1 Types of settlement Stock options can be equity-settled or cash-settled, as specified in the arrangement. In some cases, the employee has a choice as to how they will be settled. The implications of these two methods of settlement are summarized in the table below. For this comparison, the following example has been used: An employee was issued 100 options on January 4, Year 1. Each option has an exercise price of $30 and a vesting period of four years, and the options expire in 10 years. If the employee leaves during the vesting period, the options are forfeited. Each option has a fair value of $7 at the date of grant. On November 5, Year 6, the employee decides to exercise his options when the market price of the company's share is $40. The table below explains the implications if the arrangement stipulates: | Arrangement requires equity settlement | Arrangement requires cash settlement | |---|---| | **Impact for employee when exercised** | Employee pays $3,000 ($30 x 100) to exercise all the options and receives 100 shares in return. The employee can then sell these 100 shares in the market and receive cash of $4,000 ($40 x 100). The employee has earned $1,000 by selling at the market price. (Alternatively, the employee can keep the shares and sell them at a later date for whatever the market price is on the selling date.) | Employee receives cash of $1,000 [($40-$30) x 100], equal to the difference between the market price and the exercise price. | | **Downside risk for the employee** | The share price remains below the exercise price and therefore the options are worthless. | The share price remains below the exercise price and therefore the options are worthless. | | **Impact on company** | The company receives cash of $3,000 and issues 100 shares. There is dilution to its shareholders from the additional shares that are issued. | The company pays out cash of $1,000. There is no dilution to its shareholders, as no additional shares are issued However, the company now has less cash, which can increase debt or reduce its ability to invest in other opportunities. | | **Accounting impact** | Over the vesting period, the fair value of the stock options - $700 ($7x100) at the date of grant - is recognized as an expense with an offsetting increase to equity. No changes in the cost are recognized, because the employee did not leave during the vesting period. Therefore, there were no forfeitures. | Over the vesting period, the fair value of the stock options at the date of grant is recognized as an expense with an offsetting increase to liabilities. Initially, $700 is recognized, but this changes over time. | ### 35.2a Let's look at an example Elaine Wong is an employee with Immersion Software Inc. On January 7, Year 1, the company granted Elaine 1,000 stock options. Each option expires in eight years and has a vesting period of three years. The exercise price is $25 per share. The fair value of each option at the grant date is $4. The market price of Immersion Software's shares on the grant date was $17 per share. These options will be equity-settled. Based on this arrangement, Elaine can exercise the option at any time after January 7. Year 4 (three-year vesting period) and before January 7. Year 9, eight years after the options were granted. On March 30, Year 6, the market price of Immersion Software's shares is $30 per share. Elaine exercises all the options, pays $25.000 (1,000 x $25.00) to Immersion Software, and in return receives 1,000 shares. Elaine can then sell these shares in the public market for $30 per share or keep them to sell at a later date. Notice that Elaine will only exercise the options if Inmersion Software's share price increases above $25, the exercise price. If this does not happen during the exercise period, then these options expire and become worthless. The fair value of $4 for each option is used to calculate the expense of this award. In this case, the fair value of the options granted is $4 000 ($4 x 1,000) and this is expensed over the vesting period. ### 35.3 Restricted share units and performance share units RSUs and PSUs represent a promise by the employer to issue a certain number of shares in the future, once certain vesting conditions have been met. The vesting conditions for RSUs are solely based on continuing employment over a period of years. The vesting conditions for PSUs are the achievement of pre-established performance goals. Therefore, the only difference between RSUs and PSUs is the nature of the vesting requirements. As the vesting requirements are met, the employee receives shares in the company. The value of these shares will depend on the market value at the time they are issued to the employee. Similar to stock options, RSUs and PSUs are forfeited if the vesting conditions are not satisfied. ### 35.3.1 Types of settlement Similar to ESOS, RSUs and PSUs can be equity-settled or cash-settled, as stipulated in the arrangement. The implications of these two methods are summarized in the table below. For this comparison, the following example has been used: An employee was given 1,000 RSUs on January 4, Year 1. Each RSU will vest after four years, provided that the employee stays with the company. If the employee leaves during the vesting period, the RSUs are forfeited. Each RSU has a fair value of $15 at the grant date. In January. Year 5, the vesting period is completed and all vesting conditions have been met. When the shares are issued, the market price per share is $50. | Arrangement requires equity settlement | Arrangement requires cash settlement | |---|---| | **Impact for employee after the vesting period** | The employee receives 1,000 shares that are worth $50,000 ($50 × 1,000). The employee will always receive shares - it is the future value of the shares that is uncertain. The lower the share price is, the lower the value of the shares will be. | The employee receives cash of $50,000 ($50 x 1,000), equal to the current market price multiplied by the number of share units issued The employee will always receive cash- it is the amount of cash received that is uncertain The lower the share price is, the lower the amount of cash received will be. | | **Downside risk for the employee** | The share price is, the lower the value of the shares will be. | the lower the share price is, the lower the amount of cash received will be. | | **Impact on company** | The company issues 1,000 shares. There is dilution to its shareholders from the additional shares that are issued. | The company pays out cash of $50.000 There is no dilution to its shareholders as no additional shares are issued. However, the company now has less cash, which can increase debt or reduce its ability to invest in other opportunities. | | **Accounting impact** | Over the vesting period, the fair value of the RSUs at the grant date, $15.000 ($15 1,000), is recognized as an expense with an increase to equity. No changes in the cost are recognized, as the employee did not leave during the vesting period. Therefore, no forfeitures took place. | Over the vesting period, the fair value (intrinsic value is used instead under accounting standards for private enterprises (ASPE]) of the RSUs at the date of grant, $15,000, is recognized as an expense with an offsetting increase to liabilities. | ### 35.4 Share Appreciation Rights SARs are a form of compensation that is based on the increase in the company's share price over a specified benchmark price, over a specified period of time. For example, an employee is given 100 SARs that have a benchmark price of $40 and a time period of two years. At the end of two years, the company's share price is $65. Each SAR is worth $25 ($65-$40), and the employee will receive $2,500 as compensation. ### 35.4.1 Types of settlement Similar to other forms of share-based compensation, SARs can be equity-settled or cash-settled, as specified by the arrangement. If the SAR is equity-settled, the number of shares given is determined by calculating the amount the employee will receive divided by the current share price. The implications of these two methods are summarized in the table below. For this comparison, the following example has been used: An employee was given 200 SARs on January 4, Year 1. Each SAR has a benchmark price of $30 and a term of three years, and they vest after one year. Each SAR has a fair value of $10 at the date of grant. At the end of three years, the market price of the company's share is $75. | Arrangement requires equity settlement | Arrangement requires cash settlement | |---|---| | **Impact for employee after the vesting period** | The employee receives shares that in total are worth $9,000 [($75- $30) x 2001. The employee receives 120 shares ($9,000/$75).. If the share price falls below the benchmark price, the SAR is worthless and the employee receives nothing after the vesting conditions are met. The company issues 120 shares. There is dilution to its shareholders from the additional shares that are issued. | The employee receives cash of $9.000 ($75-$30) x 200). If the share price falls below the benchmark price, the SAR is worthless and no cash is received. | | **Downside risk for the employee** | If the share price falls below the benchmark price, the SAR is worthless and the employee receives nothing after the vesting conditions are met. | The share price falls below the benchmark price, the SAR is worthless and no cash is received. | | **Impact on company** | The company issues 120 shares. There is dilution to its shareholders from the additional shares that are issued. | The company pays out cash of $9,000. There is no dilution to its shareholders as no additional shares are issued. However, the company now has less cash, which can increase debt or reduce its ability to invest in other opportunities. | | **Accounting impact** | Over the vesting period, the fair value of the SARs at the date of grant, $2,000 ($10 x 200), is recognized as an expense with an offsetting increase to equity. There are no changes in the cost recognized, as the employee did not leave during the vesting period. Therefore, no forfeitures took place. | Over the vesting period, the fair value (intrinsic value under ASPE) of the SARs at the date of grant, $2,000, is recognized as an expense with an offsetting increase to liabilities. | ### 35.5 How is share-based compensation valued? The fair value of stock options, RSUS, PSUs, and SARs is determined using an option pricing model. Option pricing models are used to estimate what the share-based payment would sell for in the market (that is, its fair market value), given its terms, underlying share characteristics, market interest rates, and future expectations. In practice, the Black-Scholes model is the most commonly used method for determining the value of a share-based award. (The binomial model can also be used.) These modelled future values, along with other variables, are then used to determine the share-based award's estimated fair market value. The variables used in the Black-Scholes model, how they are estimated, and their impact on the fair value of an ESO are summarized below: | Variable | Issued by a publicly traded entity | Issued by a private company | Implications to fair value | |---|---|---|---| | Underlying share value | Market price of the company's shares at the date when the option is being calculated. | The fair value of a share is calculated using a valuation technique (see the Valuation - Big Picture chapter for more information on this topic). | The higher the share price is, the higher the fair value of the option will be. | | Exercise price of the option | As given for the option. | As given for the option. | The higher the exercise price is, the lower the fair value of the option will be. | | Underlying share price volatility | Based on historical prices of the company's shares over the same period as the term of the option. | Based on historical volatility of returns in the company's industry over the same period as the term of the option. | The higher the volatility is, the higher the fair value of the option will be, because there is a greater chance of share price changes. | | Risk-free interest rate for the option term remaining | Prevailing yield on risk-free instruments at the date the option is valued. | Prevailing yield on risk-free instruments at the date when the option is valued. | The higher the risk-free rate, the higher the fair value of the option will be, because the present value of the exercise price will be lower. | | Time until expiration (or expected life) of the options | As given for the option. | As given for the option. | The longer the expiration period is, the higher the fair value of the option will be, because there is a greater chance that the share price will increase. | The intrinsic value of an option is equal to the market share price less the exercise price. The option is in-the-money if the share price is higher than the exercise price. Its intrinsic value is therefore greater than zero. The option is out-of-the-money if the share price is less than the exercise price. Its intrinsic value is therefore zero. The difference between the fair value of the option and its intrinsic value represents the value of its future expectations (that is, the expectation of the option being worth more in the future than it is worth now). The longer the time to expiration is, the higher the option's fair value will be as compared to its intrinsic value. Also, the higher the volatility of the underlying share price is, the higher the fair value will be as compared to the option's intrinsic value. This is due to a greater chance that the share price will change, allowing it to increase above the exercise price in the future. For example, an option has an exercise price of $5 with six years until it expires. If the current market share price is $17, this option is in-the-money and its intrinsic value is $12. If this option has a fair value of $16, the $4 difference between the fair value of the option and its intrinsic value represents the value of future expectations of what this option could be worth before it expires. If, instead, the current market share price is $3, this option is out-of-the-money and its intrinsic value is SO. It will still have a fair value greater than zero. The intrinsic value of the different types of share-based compensation will be as follows: * **Stock option:** Current share price minus exercise price * **RSU:** Current share price * **SAR:** Current share price minus benchmark price ### 35.6 Objectives of using share-based compensation Companies can include share-based payments as part of their total compensation packages for the following reasons: * To align employees' and shareholders' interests and ensure that decisions enhance shareholder value over the long term * To attract and retain key personnel by using long vesting periods with forfeiture if employees leave during the vesting period * To reduce the amount of cash required to pay for total compensation * To base part of the compensation on performance of the company's share price, rather than guaranteeing total compensation * To be more tax efficient for employees in comparison to salary Stock-based compensation is common in startups (that is, early-stage and venture-backed companies in which a public market for the shares is anticipated) as well as with established companies. Startup companies tend to use ESOs both to incentivize their executives and employees and to attract long-term staff, while larger companies can use combinations of ESOS, RSUS, PSUs, and SARs. This is because startups tend to be riskier than long-standing, established corporations that have a record of proven performance. For growth-oriented smaller companies, ESOs also offer an effective way to preserve cash while giving employees an opportunity to share in the future growth of the company. On the other hand, share-based compensation plans are used less often in small, closely held companies without plans to go public or be sold, due to the limited opportunity for liquidity of such shares. It can also be difficult to determine the fair value of the underlying share price required to establish the fair value of the share-based compensation and settlement values. ### 35.7 Share-Based Payments to Non-Employees Share-based payments to non-employees are recognized at the fair value of the services or goods received at the date the services or goods are provided to the company. Generally, these payments are in the form of shares or stock options. ### 35.7a Let's look at an example **Shares:** Marks Advertising Inc. (Marks) recently provided advertising services to Lighthouse Software Ltd. (Lighthouse). The fair value of the advertising services provided was $50,000. In return, Lighthouse issued 5,000 shares (with a current value of $10 per share) to Marks as consideration for these services. ### 35.7b Let's look an example **Stock options:** Instead of shares, Lighthouse issued 30,000 options to Marks for the advertising services provided. These options vest immediately and have an exercise price of $10 (the current selling price per share). The options expire in one year and are valued at $50,000, the fair value of the services received. The downside risk to Marks is that if the selling price per share does not increase, it will not receive the fair value of the advertising services ($50,000). However, if the share price appreciates Marks can receive more than the fair value of the advertising services. Lighthouse benefits by not having to pay cash for the advertising services. However, if the share price appreciates, this will result in Lighthouse paying more than the fair value of the advertising services. ### 35.8 Choice of cash-settled or equity-settled share-based compensation The following factors are considered in assessing whether the share-based award should be equity-settled or cash-settled: | Category | Advantages | |---|---| | Equity-settled | * The company is growing and has little cash available. * The amount of the compensation expense is set at the time of the grant and only changes for forfeitures (with a cash-settled award, the expense will change each period as the fair value changes). | | Cash-settled | * Existing shareholders do not want to dilute their holdings. * The company can use a tax deduction (as cash-settled awards are usually tax deductible). | ### 35.8a Let's look at an example **Dilution of existing shareholders:** Inmersion Software has 60,000 stock options outstanding with an exercise price of $5. On March 29, Year 4, the company has 1.000.000 shares outstanding, and the company's total equity value is $20,000,000 before factoring in the dilutive effect of the employees' options that are in-the-money. The dilution affects both the share price and the existing shareholders' proportionate ownership. These dilutive effects are shown below. **Dilution of value:** * Price per share before factoring in the dilutive effect of the options: $20,000,000/1,000,000 shares = $20 per share * **Dilutive impact:** Number of new shares issued is 60,000 if all the options are exercised. The company receives $300.000 ($5 × 60,000). * **Diluted price per share:** ($20,000,000 + $300,000) / (1,000,000 + 60,000) = $20,300,000 / 1,060,000 = $19.15 Existing shareholders have each share diluted by $0.85 ($20 - $19.15). Generally, the more stock options that are outstanding and the lower the exercise price is, in comparison to the current market price, the more dilutive the stock options will be on share value. **Dilution of proportionate ownership:** In addition, existing shareholders' percentage ownership has been reduced from 100% to 94.3% [1,000,000/ (1,000,000 + 60,000)]. For example, if an existing shareholder owns 50,000 shares prior to the exercise of the stock options, this shareholder has a proportionate ownership of 5% (50,000/1,000,000). After the exercise of the options, the proportionate ownership of this shareholder is now diluted to 4.7% (50,000/1,060,000). ### 35.9 Other considerations ### 35.9.1 Can encourage risk-taking behaviour Share-based compensation is intended to align employees' interests with those of the existing shareholders. In some cases, share-based compensation could actually encourage risk-taking behaviour by managers in order to influence share prices, which could have adverse long-term consequences for shareholders. For example, options are more valuable if the underlying share price has higher volatility. Managers could make decisions that would cause volatility in the share price, hoping the share price will increase above the exercise price of their options. ### 35.9.2 Dilution As shown above, equity-settled share-based compensation dilute existing shareholders' share value and ownership. As a result, they are always considered in the calculation of the diluted earnings per share. These compensation arrangements are also scrutinized by analysts and investors, causing a reduced anticipated share price in cases where they are perceived to be excessive. ### 35.9.3 Strategy and governance Share-based compensation plans must take into account applicable laws, such as securities registrations and regulatory disclosure requirements. Officers, executives, and other insiders must disclose securities transactions - including the granting of stock options - to the appropriate regulatory agencies. ### 35.9.4 Income taxes Share-based compensation will affect employees' personal taxes and the company's corporate income taxes. The tax consequences for both the employee and the corporation depend on a variety of factors, including the following: * The fair market value of the share at the time the share-based awards are granted * The type of share-based compensation used * The award is cash-settled or equity-settled * The date that the award is settled * The entity's status of private company or publicly traded company Taxation of share-based awards is a complex area, and the Income Tax Act should be consulted to gain a better understanding of this topic. ### Lesson 2: Share-Based Payments - Summary Problem **Technical competency:** 5.2.3 Evaluates sources of financing **Learning outcome:** * Apply knowledge of share-based payments to a scenario. **Summary Problem** Sunrise Inc. is a private company that is planning to go public in the next two or three years. As a startup tech company, it is growing quickly and wants to preserve its cash as much as possible to finance this growth. Sunrise's owner and sole shareholder Sam Wong would like to implement a share-based compensation plan as part of the five key employees' remuneration in order to retain staff and conserve cash. However, Sam cannot decide between stock options or RSUS. The company recently had a valuation completed, and each outstanding share is estimated to be worth $6. Currently, the company has 500,000 shares outstanding, all owned by Sam. The two proposed plans are as follows: 1. **Issue 20,000 stock options to each of the five key employees (100,000 stock options in total). The stock options will have an exercise price of $6 and expire in 10 years. The options will vest at the end of four years.** 2. **Issue 18,000 RSUS to each of the five key employees (90,000 RSUS in total). The RSUs will vest at the end of four years.** If employees leave during the vesting period, the awards are forfeited. Based on projections and advice from investment bankers, Sam anticipates that at the end of four years, the company will be publicly traded with a share price of at least $75 per share. **Required:** Sam has hired an advisor, to determine which plan would be best for the company and has requested a report that addresses the following: * An explanation of the different share-based compensation plans, assuming that all awards are exercised or settled at the end of four years, when the share price is at $75. * The impact on the company's debt-to-equity ratio * A recommendation on which proposal for the employees, the company, and himself, the sole shareholder. **Report to Sam Wong** **Solution** As requested, the following report explains the two proposed share-based compensation plans that you are considering and, in particular, addresses the implications of equity-settled versus cash-settled plans. * The impact on the debt-to-equity ratio of your company * The advantages and risks of each plan for the employees, the company, and you, the sole shareholder. **A recommendation based on my assessment of these issues is also included.** ### 1. Stock option plan Below, I have discussed the differences between cash-settled and equity-settled stock option plans. I have assumed that the options will be exercised at the end of the four-year vesting period when the shares of the company are valued at $75 per share. The advantages and risks of both cash-settled and equity settled options for the company, you, and the sole shareholder, are listed below: | Category | Equity-settled | Cash-settled | |---|---|---| | **Employee advantage** | Assuming that the share price is $75 at the date of exercise, the employee will pay $6 per option and receive a share worth $75. The employee can immediately sell the share in the public market and receive a net gain of $69 per share. | Assuming that the share price is $75 at the date of exercise, the employee will receive cash of $69 per share from the company. | | **Employee's downside risk** | The risk is that the share price is less than the exercise price of $6. The employee has six years after the vesting conditions are met until the option expires. As long as the share price is higher than $6 during these six years, the option will have value for the employee. | The risk is that the share price is less than the exercise price of $6. The employee has six years after the vesting conditions are met until the option expires. As long as the share price is higher than $6 during these six years, then the option will have value for the employee. | | **Company advantages** | If the employee leaves during the vesting period, the options are forfeited. Cash is preserved because the options are settled in shares. The reporting expense of the options is fixed at the time of the grant, based on fair value, and recognized as an expense over the vesting period. The offsetting amount is reported in equity. | If the employee leaves during the vesting period, the options are forfeited. The reporting expense of the options will initially be recorded at fair value at the time of the grant. It changes, both increasing or decreasing. over time up to the date of final settlement. | | **Company's downside risk** | Because equity is increased, the debt-to-equity ratio is improved. | As a result, the debt-to-equity ratio can improve or worsen, depending on the changes to the liabilities over the vesting period. | | **Shareholder's downside risk** | Existing shareholders could be upset with the potential dilution of ownership and could then sell their shares. Potential shareholders could choose to not invest if they feel that too many options have been issued. The share price could then be diluted. | The fair value of the options at the grant date is recognized as an expense and an offsetting liability throughout the vesting period. Annually, the liability will be adjusted to its fair value, and any difference is expensed. The increase in liabilities will negatively affect the company's debt-to-equity ratio. However, a potential decrease in liabilities would positively affect the debt-to-equity ratio. | ### 2. RSUs I have discussed the differences between cash-settled and equity-settled RSUS below. Again, I have assumed that at the end of the vesting period when the RSUs are settled, the company's share price is $75. | Category | Equity-settled | Cash-settled | |---|---|---| | **Employee advantage** | Assuming that the share price is $75 at the date of settlement, the employee will receive one share for each RSU, and each share will be worth $75. | Assuming that the share price is $75 per share at the date of settlement, the employee will receive cash of $75 for each RSU from the company. | | **Employee's downside risk** | If the employee leaves during the vesting period, the options are forfeited. The lower the share price is at the date of settlement, the lower the value of each share received will be. An RSU will never be worthless as long as the share has some value. Therefore, there is less downside risk with an RSU. | If the employee leaves during the vesting period, the options are forfeited. The lower the share price is at the time of settlement, the lower the amount of cash per share received will be. | | **Company advantages** | Cash is preserved because the RSUs are settled in shares. The company will issue 90,000 shares. The reported cost of the RSUS is fixed at the time of the grant, based on fair value, and recognized as an expense over the vesting period. The offsetting amount is reported in equity. | The reported cost of the RSUS will change during the vesting period, as the liability has to be adjusted to fair value at each reporting period. The expense is recognized over the vesting period, and the offsetting amount is reported in liabilities. | | **Company's downside risk** | Because equity is increased, the debt-to-equity ratio is reduced. | Cash is required to settle the RSUs at the end of the vesting period. Liabilities are increased, which will negatively affect the company's debt-to-equity ratio. | | **Shareholder's downside risk** | Existing shareholders could be upset with the potential dilution of ownership and could then sell their shares. Potential shareholders could choose to not invest if they feel that too many RSUs have been issued. The share price could then be diluted. Dilution of share price and ownership on settlement of the RSUs, as 90,000 shares are issued and no cash is received. The dilution for the existing shareholder is from 100% to 84.7% (500,000/590,000). | Less cash is available for additional opportunities (capital investments) and dividend payments. | As the company is not yet public, a valuation will be required to estimate the current market value per share. This value is required to recognize the expense and liability for both the stock options and RSU's compensation plans. **Recommendation** In the case of the RSUs, there is less of a downside risk for the employee. As the value of the share price falls, the value of the RSU falls. However, as long as the share has value, the RSU will never be worthless, as it would have been with an option. The option has six years after it is vested for the employee to exercise. So, if the share price is below the exercise price, six more years of time remain prior to expiration during which the option is still valuable. On settlement, assuming that the awards are equity-settled, 90,000 shares are issued if the RSU proposal is implemented, and 100,000 new shares if the stock option proposal is implemented. My recommendation is that the company implement the equity-settled R